Understanding Section 1031 Tax-deferred Exchange

Every individual who wishes to take full advantage of the benefits of Section 1031 Exchange must understand that each transaction is different. Although there are rules and procedures that apply to everyone in general, successfully accomplishing one's investment objectives entails exercising due diligence and consulting the right professionals for some much needed legal and fiscal advice.
Unlike regular transactions where a property owner is taxed on gains earned from sales, tax on a Section 1031 Exchange gain is deferred. This is possible because the Internal Revenue Code's Section 1031 states that an exchange of property that is held for trade, business, or investment purposes recognizes neither gains nor losses. Theoretically, a taxpayer's investment did not change in any other way other than its form, so it would only be fair for him or her not to be obligated to pay tax.

This should not mean, however, that a Section 1031 exchange is tax-free. It is only tax-deferred and when the time comes for the replacement property to be sold, the gain from the original transaction, in addition to any other gain realized since the replacement property was purchased, will be subjected to tax just like every other form of transaction.

1031: You Can't Have Something for Nothing

Ever wish you can just, literally, swap your property with another one from somewhere? Section 1031 of the Internal Revenue Code allows you to do just that, as long as the property that you want is for investment or production purposes only. The new property only has to be somewhat similar to the old one that you have, although the word “similar” is very subjective and adds difficulty to the transaction.

This is why most real estate exchanges are facilitated by reliable exchange companies that can help you find a brand-new property and swap it with another one of your own. They make sure that the property you've swapped with doesn't saddle with you any unlawful gains or losses and that you're only required to pay little or no tax during exchange. However, 1031 requires that any property being swapped needs to be properly identified and exchanged within 180 days after the transaction was made, or else the Internal Revenue Service (IRS) won't recognize the transaction.

Businesspeople can use 1031 to change the form of their investment without getting any attention from the IRS. Real estate investors can also use the 1031 to, say, sell off a single-family home in exchange for a condominium or apartment unit, or a hotel for an office building. This is known as exchanging like-kind real estate and has been practiced by investors for at least 30 years now.

On Having Yourself a 1031 Vacation

Vacation homes are wonderful places to go to when you need a brief respite from the rat race. However, you may be considering selling it at some point in the future and using the proceeds to buy a second place – with the danger of incurring high taxes. If you can't handle that possibility, the Internal Revenue Service allows swaps under Section 1031 safe harbor rules, but only for pitfalls as far as the relinquished and replacement properties are considered.

For the relinquished property, the IRS states that you should have owned it at least two years before the exchange. At the same time, during each pre-exchange year, you must have rented out the place for at least two weeks. You cannot use the house for up to two weeks or the equivalent of ten percent of the rental days at market rates.

On the replacement property, you will have to own the property for at least two years after the exchange. For each of those two years, you can rent it out for a maximum of two weeks, plus your personal usage should be limited to anywhere close to two weeks.

A section 1031 exchange on a vacation home can help you save some taxes in the long run. You should take note, that full-time personal use is prohibited, but you can make money out of the place by renting it off.

A 1031 on Residential Property? It's Possible

Section 1031 of the Internal Revenue Code, also known simply as 1031, defers taxes for gains on any property or asset if they're reinvested in a like-kind exchange. If you sold a $100,000 property for twice the amount, the $100,000 gain won't be subject to tax as long as it's invested in another property. This is in line with what Section 1031 actually says. It states that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business.”

Speaking of trade or business, does this imply that simple homeowners aren't qualified for a 1031? While it states that the property must be for productive use, experts say homeowners can file a 1031 in a number of instances. In this case, you need to know the so-called “two-of-the-last-five-years rule” where the homeowner must have lived in the house for two years. It also states that the house has been turned into an investment property for the next three years.

One way to turn a residential property into an investment is by renting it out. Homeowners can move out of the house after their second year of residing there, but have to rent it out for the next three years to qualify for a 1031. Make sure you don't make your new home your primary residence before the two-year period, although there are efforts to reduce the time frame to just one year.

Navigating the 1031 Exchange Minefield

Doing a Section 1031 exchange transaction may be one way to help process your property as you swap it for another. This is especially true when you're dealing in real estate or other large tangible assets. However, doing a 1031 carries a lot of potential dangers, to the point that it can blow your finances out of the water if you're not careful. Here are some tips to avoid that.

As 1031 exchanges mostly deal on like-kind property, this is often misinterpreted as a tit-for-tat thing; some experts say that like-kind property deals with its intended purpose instead of type, such as a rental house for a tract of land. It is important for a taxpayer to familiarize with all of the key regulations during the structuring of the exchange.

If you've relinquished your property, you only have 45 days to find a replacement property, but do not wait until the last few days to start looking. Time is of the essence because you cannot mark a replacement property when the window has closed. If you do decide to sell a property and closed the deal, forget about a sudden change of plans to do a 1031 exchange.

These are only a few dangers you can prevent at the early stage of a 1031 exchange. A credible 1031 specialist can help you get all your bases covered.

What Should and Shouldn’t be Done in Real Estate Exchanges

Disposal and acquisition of property under the 1031 Exchange section of the Internal Revenue code can be complicated, but it is more lucrative than other real estate investments. Under this section, a property can be swapped for another if they are like-kind or of the same types (i.e. business-for-business like an office for a shopping center). What makes this deal sweet is its virtual exemption from capital gains taxes. For prospective investors in this profitable business undertaking, the following dos and don’ts apply as in any other venture:

Do hire a certified public accountant, real estate agent, or any financial expert that has not seen your books in the last two years. The Internal Revenue Service publication 544 disqualifies monetary professionals who have worked on your behalf from handling property trades.

Do be mindful of the time element. A 1031 exchange has 180 days to be completed, with 45 days to spend in identifying a suitable property. Remember that there are no extensions for these transactions, and that holidays and weekends are included in the six-month period allotted to close the deal.

Do not trade in a property that has lesser value than the one you’re looking at. In such cases, capital gains taxes will kick in (any excess money from the exchange is taxable).

Things to Consider when Planning to Exchange Property Under Section 1031

There are several important things that one should keep in mind when taking advantage of the tax-deferred 1031 property exchange. First, it should be clear that under Section 1031, the provision is only applicable to properties that are in use for investment and business purposes only. This means that one's residence cannot be swapped for a new dwelling.

When it comes to vacation homes and other secondary types of residences, the drawing line is less clear. 1031 may be utilized in these exchanges, although rules set by Congress since 2004 had tightened restrictions on this matter, especially if one decides to re-purpose the new property into a house for rent. For specifics, consult an industry professional.

The provision states that exchanges must be of the same type, but it doesn't have to be the exact same type when it comes to real property. A piece of real estate, for example, can be exchanged with another type of property, whether it's an empty lot or an apartment unit. This does not extend to personal property, where rules are stricter. A car cannot be exchanged with a truck, for example.

Furthermore, several types of what can be ascribed to being a property, are not eligible for exchange under the 1031 provision. This include inventory or stocks in trade, bonds, notes, securities and debt. Likewise, partnership interests or certificates of trust are not exchangeable under 1031.